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Translation Exposure. Chapter Ten Eitman, Stonehill, and Moffett. Translation exposure. foreign currency financial statements different line items translated at different exchange rates term of different assets & liabilities translated at historical rates current rates.

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Presentation Transcript
translation exposure

Translation Exposure

Chapter Ten

Eitman, Stonehill, and Moffett

ESM Chapter Ten - Translation Exposure

translation exposure1
Translation exposure
  • foreign currency financial statements
  • different line items translated at different exchange rates
  • term of different assets & liabilities translated at
    • historical rates
    • current rates

ESM Chapter Ten - Translation Exposure

foreign subsidiaries
Foreign subsidiaries
  • Integrated foreign entity
    • Extension of parent firm
    • Cash flows denominated in functional currency
    • Supplier to the parent firm
  • Self-sustaining foreign entity
    • Operates independently in foreign environment
    • Cash flows denominated in foreign currency
    • Supplied by local economy
    • Supplies local economy

ESM Chapter Ten - Translation Exposure

functional currency
Functional currency
  • Primary economic environment of the firm

ESM Chapter Ten - Translation Exposure

balance sheet
cash

market securities

receivables

inventories

fixed assets

payables

accruals

fixed debt

common stock

pd in capital

acc. Retained earnings

Balance sheet

ESM Chapter Ten - Translation Exposure

income statement
Income statement
  • Revenues
  • (Costs)
    • (COGS)
    • (Operating costs)
    • (Depreciation)
  • (Taxes)
  • Net Income
    • retained
    • distributed

ESM Chapter Ten - Translation Exposure

types of foreign firms
Types of foreign firms
  • integrated foreign entity
    • one which operates as an extension of the parent firm
    • functional currency is that of the parent firm
  • self-sustaining foreign entity
    • one which operates independently of the parent firm
    • functional currency is that of the foreign country

ESM Chapter Ten - Translation Exposure

determining the functional currency
Determining the functional currency
  • intercompany transactions
    • large volume - use parent currency
    • small volume - use foreign currency
  • large volume determined by a large split between revenues and costs
    • sales price responsive more to exchange rate changes
    • costs due to importing components from parent company
    • interest costs on financing in home currency

ESM Chapter Ten - Translation Exposure

current method historical
Current method (Historical)
  • balance sheet items at current rate
  • income statement items
    • exchange rate in effect on dates incurred
    • average exchange rate over the period
  • distributions - rate on date of payment
  • equity
    • equity & pd in capital historical rates
    • retained earnings at historical
  • cum translation adj - on consolidated BS

ESM Chapter Ten - Translation Exposure

rationale for using current method
Rationale for using current method
  • if relative PPP holds
    • real assets depreciate in foreign currency terms
    • real assets retain constant value in home currency terms
    • monetary (financial) assets do not have time to depreciate
  • if relative PPP does not hold
    • case is the same as that of a firm in an inflationary or deflationary climate

ESM Chapter Ten - Translation Exposure

temporal
Temporal
  • balance sheet items - stock statement
    • monetary assets & liabilities - current rate
    • non-monetary assets & liabilities - historical rate
      • inventories may be assigned as current assets
  • income statement items - flow statement
    • most items - average rate
    • except cashflows associated with non-current assets or liabilities translated - historical rate
      • depreciation

ESM Chapter Ten - Translation Exposure

temporal1
Assets

Cash

marketable securities

accounts receivable

inventories

fixed assets

Liabilities

accounts payable

notes payable

accruals

long-term liabilities

equity

Temporal

ESM Chapter Ten - Translation Exposure

temporal2
Temporal
  • revenues
  • (cost of goods sold)
  • (operating costs)
  • (amortization)
  • (depreciation)
  • (Taxes)
  • Net Income

ESM Chapter Ten - Translation Exposure

rationale for using temporal method
Rationale for using temporal method
  • This reflects normal evaluation
    • Book values are used
    • monetary (financial) assets do not have time to depreciate
  • if relative PPP does not hold
    • case is the same as that of a firm in an inflationary or deflationary climate

ESM Chapter Ten - Translation Exposure

balance sheet hedge
Balance Sheet Hedge
  • Must match foreign denominated liabilities to assets
    • Borrow the expected change in equity
      • Based on an expected future spot
      • Convert to home currency now
    • Sell assets equivalent to change in equity
      • Convert to home currency now

ESM Chapter Ten - Translation Exposure

current
cash

market securities

receivables

inventories

fixed assets

payables

accruals

fixed debt

common stock

pd in capital

acc. Retained earnings

Current

ESM Chapter Ten - Translation Exposure

temporal3
Assets

Cash

marketable securities

accounts receivable

inventories

fixed assets

Liabilities

accounts payable

notes payable

accruals

long-term liabilities

equity

Temporal

ESM Chapter Ten - Translation Exposure

justifying a balance sheet hedge
Justifying a Balance Sheet Hedge
  • Liquidation of current foreign operations in the short to medium term
  • Maintenance of debt covenants
  • Subsidiary operating under hyperinflation

ESM Chapter Ten - Translation Exposure

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